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PepsiCo Beats EPS; Misses Sales

PepsiCo Inc.’s (PEP) second quarter 2012 earnings per share (“EPS”) declined 7% year over year to $1.12 hurt by a sluggish top line and currency and commodity cost headwinds. Foreign exchange pulled down earnings by 3% as the company carries out a substantial part of its business outside U.S. However, EPS edged past the Zacks Consensus Estimate of $1.09 helped by price increases and cost savings. At the call PepsiCo affirmed its previously provided 2012 outlook.

Top-Line and Margin Details

Total sales in the quarter declined 2% year over year to $16.45 billion mainly due to structural changes and foreign exchange headwinds. Foreign exchange negatively impacted revenues by 3% while the beverage re-franchising transactions in Mexico and China pulled down revenue by 4%. Excluding these two factors, revenue increased 5% on an organic basis helped mainly by price increases. Price/mix added 4% while volumes added 1% to total revenue growth. Revenues however missed the Zacks Consensus Estimate of $16.7 billion.

PepsiCo is the largest food and beverage company in North America and the second largest in the world. The Global Snacks revenue of PepsiCo grew 4% while global beverage volumes declined 8%. Organically, however, snacks grew 8% and beverages increased 2%. Nutrition products revenue increased 2.5% organically.

To counter the maturing North American market, PepsiCo has of late concentrated more on its international business which is relatively untapped by other companies. Emerging and developing market revenue was down 8%. However, excluding the impact of the beverage re-franchising actions in China and Mexico and foreign exchange headwinds, organic revenue in the these markets was up 9%.

Core operating profit in the quarter was down 5% (down 2% in constant currency) to $2.67 billion mainly due to currency headwinds, increased commodity costs and higher advertising and marketing spend. PepsiCo is boosting its existing brands and categories with stepped-up marketing and innovations which are expected to drive revenue growth and also enable increased price realization in the long run. In the quarter, the company increased its media spending in the U.S. by 40%. Commodity costs inflation was $350 million in the quarter.

Segment Details

All the four segments registered positive organic growth in the quarter.

PepsiCo Americas Foods (PAF): The segment which makes popular foods like Lay’s potato chips, Cheetos cheese flavored snacks and Quaker-brand cereals and snacksrecorded revenue growth of 4% (organically up 7%) to $5.72 billion. Benefits from price/mix, innovation and higher marketing spend boosted revenue growth. The segment’s core operating profit increased 2% in constant currency as productivity improvements made up for the high commodity and advertising/marketing costs.

Quaker Foods North America (QFNA): Revenue was up 1% organically to $583 million driven by price/mix gains and innovation like the launch of Quaker Real Medleys hot cereals. Core operating profit declined 7% in constant currency due to high commodity costs.

PepsiCo Americas Beverages (PAB): Net revenue at this segment, which makes popular beverages like Pepsi, Mountain Dew, Diet Pepsi, and 7UP, slipped 5% year over year (organically up 2%) to $5.35 billion. Price/mix gains of 3% were offset by re-franchising of the Mexican beverage business in the fourth quarter of 2011 which negatively impacted revenue by 7%. Core operating profit declined 13% in the quarter due to high commodity costs and increased marketing/advertising spend.

Europe: Net revenue in the segment declined 5% year over year (up 3% organically) to $3.62 billion mainly due to foreign exchange headwinds. Organic revenues benefited from price/mix gains. Core operating profit was up 15% year over year in constant currency driven largely by productivity savings.

Asia, Middle East & Africa (AMEA): Net revenue declined 8% (up 10% organically) to $1.76 billion mainly due to re-franchising of beverage business in China and foreign exchange headwinds. In March 2012, PepsiCo entered into a strategic alliance with leading Chinese food and beverage maker, Tingyi Holding Corp. whereby Tingyi’s beverage subsidiary was appointed as PepsiCo’s franchise bottler in China. Organically, revenues benefited from both price/mix and volume gains. Core operating profit was up 7% year over year in constant currency as pricing and volume tailwinds partially offset the impact from higher commodity costs.

Guidance

The company maintained its previously provided top- and bottom-line outlook for 2012. PepsiCo projects core constant currency EPS to decline in 2012 by approximately 5% from 2011 core EPS of $4.40. Currency headwinds are expected to reduce earnings growth by 3%, higher than prior expectations of 2%.

Constant currency revenues are expected to grow in the low single digits, including headwinds from the Mexican re-franchising and the Tingyi deal in China. Excluding such changes, revenues are expected to grow in the mid single digits.

Further, in 2012, the company expects to generate $8 billion in operating cash flow. However, management forecasts operating cash flow (net cash provided by operating activities less capital spending plus sales of property, plant and equipment) to be more than $6 billion. Capital expenditures are expected to decline by 10% in 2012. Moreover, the company hopes to buy back shares worth $3 billion and pay $3.3 billion in dividends.

Our Recommendation

Currently, PepsiCo has a Zacks #3 Rank (short-term Hold rating). Over the long term, we provide a Neutral recommendation on the stock.

We are encouraged by PepsiCo’s strong brand portfolio, its product and geographic diversity and solid cash flow generation. Moreover, PepsiCo’s marketing support investments, brand building innovation and cost saving efforts will boost growth in the long term.

However, a challenging consumer spending environment combined with higher commodity costs raises concern. Moreover, PepsiCo faces strong competition from The Coca-Cola Company (KO). The Coca-Cola Company commands a larger share of carbonated soft drinks (CSD) consumption in the U.S. measured channels and also enjoys higher market share in many markets outside the United States than PepsiCo.